Please Note: This Article is 5 years old. This increases the likelihood that some or all of it's content is now outdated.

Commercial property is a depreciating asset whose rate of depreciation can be slowed or offset by appreciation over a period of time. For a property to go up in value between one date and another, one or more things would have to happen.

The first question when buying for growth is why should your choice of proposition increase in value.

Property generally has a reputation as a long-term hedge against inflation. In 1973, as a first-time buyer I bought my first home, paying £9800 (£9000 mortgage) for the freehold interest in an unmodernised two-up-two down mid-Victorian terraced house with tiny garden and no on-site parking in NW London. I obtained an improvement grant of £1,000 from the Council towards the cost of a bathroom and inside toilet. During my residency, probably I spent no more than a couple of thousand pounds on kitting-out, until selling the property a few years later for £14,000. According to Rightmove, similar houses in the same street have fetched between £320,000 and £500,000 during the past couple of years: I always knew the area had potential!  The rise in residential property prices, particularly in London, has been well-chronicled and I daresay that people of my age and older that stayed put in their first home have done exceedingly well over the years. To cut a long story, having moved enough times to have been able to afford my own removals lorry, I now own a property in a locality where house prices have barely moved for the past 10 years and are unlikely to go up now that the planners have created a price ceiling by allowing more housing to be developed. The only time I got the formula right was in 1983 having bought a detached thatched cottage with a 1/4 acre garden in NW London for £50,000 and sold about 6 years later at auction for £250,000. (The buyer never occupied it, instead she sold it to my ex-next door neighbour for about £150,000, the neighbour modernised the property and resold it for £180,000. The last recorded sale was about £450,000). The moral of that autobiography is that not only was the past the best time to have bought property, but benefitting from the growth also only works if you have what it takes to stay put through thick and thin.

Since 2009, and because most people do not do anything much to contribute to the rise in value of a property, the main reason for the increase in property prices has been low interest rates. During the year 1973, when I took out my first mortgage, Minimum Lending Rate (as Base Rate was then known as) ranged between 7.5% and 13%, with the mortgage rate a few percent higher. In those days, owner-occupier mortgage interest qualified for tax relief, as did interest on money borrowed for improvements. Gradually, the Government of the times scrapped those reliefs, culminating in the early 1980s with the withdrawal of tax relief from dual-income mortgages (where two or more people combined their incomes to take out a larger mortgage on one property).

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Commercial property is a different kettle of fish entirely. Unlike residential property which usually sells for more when vacant, not let, commercial property often fetches more when let, not vacant. Ignoring the difference between price and value, any higher amount reflects the premium that investors place on the income-stream from the rent for the duration of the lease and the rental prospects. For example, a vacant property valued at say £100,000 would if let for 10 years at £10,000 a year exclusive with rent review at year 5 then probably fetch in the prevailing market approximately £200,000, presupposing Base Rate at 0.5% and LIBOR not much more.

The snag with comparing yield from commercial property investment with the cost of borrowing, and/or returns available elsewhere, is that interest rates can vary, so too can confidence in the returns elsewhere. When the ‘looking-over-your-shoulder’ approach to investing is applied to commercial property, the advantages that commercial property appear to offer compared to other forms of investment can mask the disadvantages of commercial property. For many inexperienced investors, the disadvantages of commercial property might only become apparent after completion of the purchase!

The amount of premium is the stuff of investor psychology. The impact of interest rates and the cost of borrowing on commercial property investment should never be underestimated. With Base Rate at 0.5% since March 2009 and only likely to go up sometime next year and even then unlikely by much, there is such a demand for commercial property investment that sentiment is driving market-momentum.

Momentum is a form of growth whose driving force is confidence. Confidence is a combination of trust in ability and faith. To quote Ayn Rand, “wealth is the product of man’s capacity to think.” For balance and harmony, thought requires feeling in equal measure, but – probably caused by living mind-over-matter, and in turn, since we are what we eat, caused by an over-stimulated diet (coffee and chocolate, for example) – many people have difficulty with feeling so have a propensity for thought.

Thought relies on logic, but logic is based on past experience. Trust is the feeling of now, and the risk that past experience can be relied upon safely. Faith is belief that what is happening now will continue. It all adds to a great deal of certainty, despite the probability of change. In a rising market, sentiment is great for investors that bought wisely, but extremely risky for injudicious investors. With the thought of money to be made, jumping on the bandwagon might be a good idea, but what matters more is when to jump off. The more an investor pays for a commercial property, the harder it is to maintain and increase investment premium value. Since, as I am fond of saying, investment is about becoming better off, what’s the point of buying something that as a consequence of not selling at the right time is likely to go down in value.

I am not going to spend much time exploring the art of timing in-depth here. (I am compiling content for a new in-depth informative website for launching in next few months, I’ll post the link in due course.) Suffice it to say that when you pay a premium, whether the proposition would continue to justify at least the same premium depends upon numerous factors, one of which being the term of lease. For example, a sale-and-leaseback for 15 years to a UK clearing bank is undoubtedly a blue-chip investment in the context of tenant covenant, but as a commercial property investment it might not be. At the start of the 15 years, the market would price to maximum premium (or low risk), but with only 5 years remaining, the premium would fall to high risk, because of the uncertainty whether the bank would renew its lease and on the same terms as before.

An illiquid asset, property is costly to buy, which is why most investors buy to hold for the long term. The definition of long-term is subjective/personal. For a pension plan, property, it can serve as an annuity, is considered a staple. Because there is no correlation between rental values and inflation, also the investor owns the building, not the tenant’s business, the fixed nature of property makes it essential to get the buying right, the timing and the buying price itself.

Timing is a reflection of the state of the market. The best time to buy is when credit is hard to come by. Through requiring security for the loan, (it is after all not their money to lend) the banks and mortgagees destabilise the market by relaxing borrowing criteria and only lending when they consider it safe for them to do so. A consequence is to make things easier for the borrower which, in turn, fuels and drives the premium momentum. Therefore, the worst time to buy is when sentiment is running high and the premium excessive.

When investing for growth, the question is in which market are you investing: commercial property or investment premium? Because a premium is likely to exist more often than not, your ability to buy may be borrowing-dependent, there might be no getting away from the fact of overpaying at least some if not substantial premium. With that in mind, it becomes even more necessary to ensure the technical factors for growth are overwhelmingly supportive.

Amongst the considerations for growth are that the purchase price is below market price, the property is in a growth area, and the lease contains terms and conditions that would not work against the rental growth.

Below market price is a reflection of the seller’s failure or decision not to capitalise on what might be achieved otherwise. Buyer appraisal includes whether the seller has overlooked something of a technical nature. Thinking a price cheap or good value compared to what is paid for other propositions of a similar nature elsewhere doesn’t mean the price for the particular proposition is necessarily cheap or good value. Each proposition has to be considered on its merits, in isolation.

Rental growth is a product of demand and supply. Landlords supply, tenants demand. Evidence of demand is reflected in the existence of rents and the level of rents a reflection of the non-fiscal value that tenants place on the appeal and characteristics of the locality and the property itself. Landlord assessment of suitability will often differ from that of a tenant. The tenant’s assessment is related to its own business-plan. For the landlord’s and the tenant’s assessments to be in sync, it is essential for landlord attitude towards the property to be flexible. A tenant only needs to be flexible where the tenant has no choice. Apart from landlords with starry-eyed view of their property interests, many landlords are unable, or rather unwilling, to be flexible, because the level of indebtedness to the bank (loan to value covenant) prevents the landlord from adopting a property approach to the landlord and tenant relationship.

Growth areas are a reflection of supply shortage, where the definition of shortage means premises suited to tenant requirements. In many places there is no shortage, but what’s available doesn’t suit tenants.

Lease terms and conditions are critical. When buying a ready-made investment (namely, a property already let). the terms and conditions of the existing lease will have been agreed by others. Whether those terms and conditions will withstand the test of time depends upon the experience of the parties concerned and their advisers when the lease was granted. When you let vacant property and can incorporate terms and conditions in the new lease to ensure that the landlord’s intention is properly reflected, it is important to not allow your lawyers to follow drafting precedents slavishly. but ensure that each word and phrase, particularly in a rent review clause, would not result in the landlord coming unstuck. Coming unstuck is reaching epidemic proportions. More and more inexperienced (naive) investors are buying shrewdly-marketed ready-made propositions from cunning sellers that are designed to maximise the price for the seller at the expense of the buyer. Come the rent review and not only has the buyer paid a hefty premium to the previous landlord, but is denied recoup from the tenant of any increase in rent by reason of the wording of the lease.

Yield compression, growth caused by difference between rental yield and cost of borrowing, distorted the market in the run-up to the 2008 crash and since then has picked up where it left off. Yield compression is investment in investment, not investment in commercial property. The difference is subtle and its reality possibly hard to fathom, but is nevertheless important. For long-term successful investment in commercial property, it is important to avoid coming unstuck in times of change.

In my opinion, there isn’t enough growth left in the system for every investor to enjoy. Frankly, that’s hardly surprising. The market is awash with so much cash and logical thinking that premium pricing (over-paying) is at full pelt. Which rather suggests that, to quote from LBG Capital No. 1 PLC; LBG Capital No. 2 PLC v BNY Mellon Corporate Trustee Services Ltd [2015] – the Lloyds Bank ECN case – “the FSA stress tests used are not forecasts of what is likely to happen but are deliberately designed to be severe”, in practice, the stress test 60% peak-to-trough fall in commercial property prices is likely to happen.

In 2008, when the money supply dried up, commercial property prices fell through the floor. The commercial property market is not upward-only. Whether it could be you left in the dark will depend upon your guiding light.

Wishing you a Merry Christmas and a Happy and Healthy New Year.

Michael Lever

 

 

 

Please Note: This Article is 5 years old. This increases the likelihood that some or all of it's content is now outdated.
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